Microsoft: Faster, Stronger, Better

By

Alexander Eule

December 19, 2015

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Since CEO Nadella took over, Microsoft shares are up 48%.
Photo: Jim Young/REUTERS/Landov

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Five months had passed since Steve Ballmer announced his retirement in August 2013, and
Microsoft
was still searching for a CEO to replace him. Investors cheered the idea of new management, but some had begun to wonder if the long wait was another sign of failure for the struggling behemoth. In recent years, Windows had become a reason to stay away from PCs, not buy them. To make matters worse, Microsoft had missed the mobile revolution driven by
Apple
and Google.

It was primed for a disruptive, outside candidate, but ultimately Microsoft (ticker: MSFT) plucked one of its own, Satya Nadella, a 22-year veteran who had most recently run its cloud efforts. It turned out to be a stroke of genius. Microsoft shares have soared 48% since Nadella’s appointment, and employees are raving about his demeanor and vision for a bolder and more empathetic company.

Microsoft, BlackRock, and Invesco Move Higher

Barron's Bounce: Shares of the software giant as well as a few asset managers are rising after the magazine made the case that they were undervalued.

Barron’s Bounce: Shares of the software giant as well as a few asset managers are rising after the magazine made the case that they were undervalued.

Freed from Ballmer’s grip, Microsoft’s Redmond, Wash., campus feels vibrant and alive—the company’s shares are up 67% if you count from the day Ballmer announced his retirement. Microsoft’s vast scale has become an asset, rather than a liability. The company is going head to head with
Amazon.com
(AMZN) in the cloud. And it’s building new hardware that rivals Apple’s (AAPL) in imagination and attention to detail. The latest Windows, a big jump in technology, was offered free to existing users for the first time. Within 10 weeks, it was running on 110 million devices.

Nadella, 48, just the third person to lead Microsoft in its 40-year history, has captured Bill Gates’ innovative style and the growth that often eluded Ballmer. The formula promises more upside for investors. Microsoft shares could rise 30% in the next 18 months, on top of the company’s 2.7% yield.

Wall Street analysts have turned optimistic about Microsoft. After the September quarter, reports featured headlines like “The New Trendy Tech Company” and “Starting to Hit Its Stride.” Still, the Street under-appreciates the opportunity, with an average price target of $57 for Microsoft shares, just above its recent quote of $54.

Many big investors believe Microsoft is worth far more. “I think we see over $70 in 18 months, and, along the way, they’re going to pay you a nice dividend. That’s a really good return in a market where a lot of stocks are pretty expensive,” says Chris Bonavico, a portfolio manager at Jackson Square Partners, which manages $28 billion in assets; its Microsoft position is worth $970 million. Bonavico’s team had a large position in Microsoft in the 1990s before sitting out what became a lost decade for the stock.

One of those expensive stocks is Amazon.com. The e-commerce giant trades at a huge price/earnings ratio, not because of its retail prowess, but because it has become a leader in the cloud. Amazon Web Services, or AWS, offers cloud-based computing for companies that increasingly want to outsource their data centers.

Since Amazon disclosed its AWS revenue for the first time in April, its shares have soared 70%. The business gives it a highly profitable segment, with operating margins over 20%, stellar for a company whose legacy e-commerce business still struggles to break even. This year, Amazon’s cloud revenue is likely to be $8 billion. That will account for nearly half of Amazon’s profit, even though it’s just 7% of sales.

Investors are paying handsomely for the cloud play—at $664, Amazon trades at 125 times expected earnings for the next 12 months. But Amazon isn’t the only outfit that can make it rain. Hidden within Microsoft is Azure, a similar cloud service that’s growing even faster than Amazon’s. Microsoft is rather opaque on Azure’s financials, but the company did say revenue grew 135% in its fiscal first quarter, which ended in September.

Mark Moerdler, a Bernstein analyst, estimates Azure revenue is roughly $1 billion and could be as high as $7.3 billion by mid-2018, with operating profit margins as good as Amazon’s or better. While bears contend a pricing war could make the cloud less appealing, Moerdler argues there’s plenty of business for both companies: “This is a huge market in which there will be more than one winner.”

For enterprises, both new and old, the cloud holds alluring economics—the ability to buy computing power on the fly. Think of a busy Web retailer that can ramp up servers in the weeks before Christmas and then spin them down after New Year’s. Microsoft Azure charges by the minute— AWS by the hour—meaning businesses pay only for what they need. It’s a stark departure from the days of building costly corporate data centers with equipment from
Cisco Systems
(CSCO), Hewlett-Packard, and
EMC
(EMC).

Microsoft contends Azure offers the most flexible approach to the cloud, allowing companies to use their private, “on premises” data centers in tandem with the public cloud. Microsoft creates the seamless connection.

At banks, for instance, that means the most sensitive data can stay physically gated from the rest of the Internet, while less-sensitive information and processing takes place in the cloud. As companies get more comfortable with the cloud, they’re likely to shift additional work to Azure; the economics are too compelling to resist.

MICROSOFT’S CLOUD BUSINESS is several years behind Amazon’s, but it has been building its own internal cloud for years, to get the most out of Office, Xbox (its gaming platform), and Bing, the No. 2 search engine after
Alphabet’s
(GOOGL) Google. Bing, which was profitable for the first time ever in the last quarter, taught Microsoft much of what it’s now applying in the cloud, including identifying patterns, a promising field known as machine learning.

Microsoft has always taken its time to get things right, says Rupal Bhansali, the chief investment officer of international equities at Ariel Investments. “Initially, Microsoft always appears to be losing the battle, but they win the war,” she says. “They weren’t big in the cloud, and today Azure is gaining rapidly. The initial Surface [tablet] did not do very well. Now, the Surface Pro 4 is sold out.”

For the present, however, investors are still treating Microsoft like a traditional software company. The stock trades at 19.5 times fiscal 2016 earnings estimates, versus 80 for cloud-based
Salesforce.com
(CRM). And the forecasts are conservative. Analysts expect Microsoft’s sales and profits to be flat this year at $93 billion and $22 billion, respectively. Boosted by an aggressive buyback program, earnings per share could still grow 5%. Wall Street expects EPS to rise another 13% in fiscal 2017, to $3.13.

Moerdler is far more bullish. He says that $3.84 is more likely in fiscal 2017 and that analysts are underestimating the growth of Azure and overlooking Microsoft’s Office transition.

The Street’s more conservative numbers are an opening for stock gains. “It creates a big opportunity for Microsoft to ‘beat and raise,’ ” says Moerdler. Indeed, the stock jumped 10% in October after Microsoft reported September-quarter EPS of 67 cents, versus a 58-cent estimate. In April, Microsoft also gained 10%, on a better-than-expected quarter.

Aside from Azure, analysts are also missing the boat on Office, the popular productivity software that includes Word, Excel, PowerPoint, and Outlook. Office has been moving to a subscription model called Office 365, which already has 18 million consumer subscribers. About a quarter of the company’s corporate users have transitioned to the program, too.

Nadella was unavailable for comment, but Amy Hood, Microsoft’s chief financial officer, views subscriptions as a game changer. “The subscription model requires that you prove your worth every month or every year,” she tells Barron’s. “And if you do that, the lifetime value of that unit is higher. And churn is low.”

Microsoft says the subscription model could boost lifetime user revenue by as much as 1.8 times, but the Street remains skeptical. Analysts initially disregarded a similar transition at
Adobe Systems
(ADBE), which began converting its Photoshop suite to a subscription model in 2011. That transition is almost complete, and Adobe has gained 150% over the past three years. The stock carries a forward P/E of 33. Says Jackson Square’s Bonavico: “We were a top shareholder of Adobe when they went through this change. Now we see it happening at Microsoft, but Microsoft is painting on a bigger canvas.”

By some math—counting the subscription Office business, Skype, Xbox, and Azure—Microsoft is already the world’s largest cloud company, with annualized revenue close to $10 billion. Microsoft has said its “commercial cloud”—Azure plus commercial Office and other business applications—will be a $20 billion annual business by 2018.

Bullish Microsoft investors, including Bonavico, think the opportunity is best viewed through the lens of free cash flow. Free cash accounts for the fact that, with subscriptions, the recognition of revenue trails the actual receipt of cash. David Pearl, co-chief investment officer at Epoch Investment Partners, thinks Microsoft will generate $3.49 in free cash flow in 2017 and $3.98 by 2018. At 18 times, he gets to a price of $72 in less than two years. And that’s without giving Microsoft any credit for the roughly $8 in net cash per share on its balance sheet. Epoch, which has $42 billion in assets, owns Microsoft stock worth $830 million.

Not Just Windows: Microsoft’s recently opened flagship store on New York’s Fifth Avenue.
Photo: Microsoft

THE EASIEST WAY TO SEE the transformation under way at Microsoft is on the ground, with its more traditional products, where Nadella is pushing employees to take risks. Over the summer, the company launched Windows 10, a major rethinking of its classic operating system.

Such launches were once a major revenue event, but this time, Microsoft made the upgrade free to consumers. The decision reflects Nadella’s recognition that Microsoft had lost the mobile battle. The company now needs a way to rebuild its ecosystem, which is splintered across 15 years’ worth of Windows versions, including XP, Vista, Windows 7, and Windows 8. The hope is that Windows 10 becomes a dominant platform. It uses the same code across desktops, tablets, and phones, so developers can easily write for every Windows device. In contrast, Apple and Google use separate software for their desktop and mobile products.

Even Skype, Ballmer’s $9 billion toy, is showing real innovation. Two weeks ago, during a visit to Redmond, Barron’s got a demonstration of Skype’s new translation technology from Peter Lee, Microsoft’s corporate vice president for research. We sat in Lee’s office while he spoke English via videochat to a colleague in Brazil. In real time, Lee’s comments were translated into Brazilian Portuguese. The replies were translated back into English—and the tower of Babel collapsed before our eyes.

The translator product was a pet project for Microsoft Research when Nadella became CEO, but he quickly saw its promise. During a public event in May 2014, three months into his tenure, he announced that Microsoft would deliver a public beta by year end. Lee recalls the reaction of his team as a “combination of terror and excitement.”

“This is the situation we’ve always wanted to be in,” Lee says. “To have a chance to go end to end and take amazing research ideas and get them into situations where they can exist and really move the needle.” Two weeks ago, Microsoft publicly launched Brazilian Portuguese translation for Skype, the software’s seventh supported language.

Other new products are symbolic of the revitalized Microsoft. In October, it introduced its first laptop, the Surface Book. A headline on Gizmodo, a tech-focused Website, declared, “So Good, I Might Switch Back to Windows.”

Last year, Microsoft opened a sprawling hardware lab on its Redmond campus. The 100,000-square-foot space houses industrial-grade 3-D printers and milling machines used to build prototypes for Surface units and other devices. Bill Maes, Microsoft’s director of prototyping, says the new lab has shortened his build time from a week to 48 hours.

THE DECLINING PERSONAL-COMPUTER market remains a head wind for Microsoft, but the company seems to have decoupled itself from the traditional world of PCs. Windows 10, the tech giant hopes, will be as important on tablets as it is on desktops, and Office 365 is now available on every kind of device, from Apple- and Google-powered phones to MacBooks and Surfaces.

Microsoft investors are warming to the concept of a less PC-centric company. Last month,
HP Inc.
(HPQ) reported its first quarter as a pure-play printer and PC business, after the spinoff of its enterprise-services unit. “The commentary about PC sales was not great,” says Deutsche Bank analyst Karl Keirstead, “but Microsoft stock didn’t even budge. That’s an interesting change in Street sentiment.”

Not that Microsoft has given up on the consumer. In October, it opened a flagship store on Fifth Avenue in New York. The front of the store showcases the Surface Book and Surface Pro, a tablet-laptop hybrid. The devices aren’t secured to the tables; the idea is to let customers hold, lift, and even move the products around the store. There’s one product, however, that’s in a sealed glass chamber: The HoloLens, a headset, is Microsoft’s most ambitious product yet, a stab at augmented reality. The device is a departure from the craze around virtual reality, which is a fully immersive experience cut off from surroundings.

HoloLens aims to work with those surroundings. The headset scans rooms to create holograms that fit on a real-life wall or table. In a promotional video, HoloLens projects instructions onto a clogged sink pipe, showing a neophyte exactly where to turn the wrench. And in the kitchen, one could imagine overlaying decorating instructions on a cake, turning the project into an easy-to-do coloring assignment.

For now, HoloLens is very much a work in progress. The headset is heavy and uncomfortable, not the kind of thing that could be worn day to day—in the office or the kitchen.

Bill Gates’ Microsoft might have launched it anyway, proud of the innovation it entailed. Steve Ballmer’s might have curtailed its ambition. But for Satya Nadella, this device holds the promise of layering Windows over everyday life—an iPhone kind of gambit. And he just might make it work.

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